Write Offs from Renting a Home
After deciding it makes economic sense to rent your old home or vacation home instead of selling it (see last month’s visit), learn the tax rules. Structure your rental activity so the rental income is at least partially tax sheltered.
The amount of your tax deductions depends on how the rental property is used.
When there is little or no personal use of the property by the owner, full tax deductions are allowed against the rental income. To qualify the home must be rented for more than 14 days during the year, and your personal use each year must be less than the greater of 14 days or 10% of the days the home is rented. Then, you can deduct from rent mortgage interest, property taxes, and any utilities or other costs you pay related to the house. Repairs and maintenance also are deductible, but improvements are not. Any improvements are added to the tax basis.
You also depreciate the tax basis of the home. This is not the tax bonanza it was years ago, but it is deductible against rental income. The basis of the home (but not the land) is depreciated over either 27.5 years or 40 years, depending on the depreciation method used. For details about the tax treatment of renting a home, see IRS Publication 527.
When the rental operates at a net tax loss, you might be able to deduct the tax loss against other income. If your adjusted gross income is below $150,000, the loss generally is deductible against other income if you actively manage the property.
When AGI is higher, the rental property is a “passive activity.” That’s the tax code term for a tax shelter. Then, the losses can be deducted only against income from other passive activities. Any passive losses that cannot be deducted in the current year are suspended until they can be deducted in the future. Details of this also are in IRS Publication 527, available free on the IRS web site www.IRS.gov.
Another factor to consider is the tax treatment from the eventual sale of the property. You have to compare the taxes due from selling the home today to the taxes from selling the home after renting it for some time. The results depend on how the home is used now.
If the home has been a second home, there are no special tax benefits from selling it today. The property is a capital asset. When sold, the difference between the sale price and the basis of the property will be taxed as a capital gain. If the property was held for more than one year, the maximum tax rate will be 15%.
When a house has been a rental property, the tax treatment of a sale is similar. The difference is that depreciation allowed during the rental period reduces the tax basis of the property. That increases the eventual capital gain from the sale.
If the home currently is the principal residence, however, significant tax benefits might be available from selling today or within a few years.
All gain from the sale of a principal residence is tax-free up to $250,000 ($500,000 for married couples). To qualify for the exemption, you must own the home and use it as a principal residence for two of the five years immediately preceding the sale. The ownership and residence periods do not have to be at the same time.
If you turn a principal residence into a rental home, you risk losing the exemption when the home is sold. This could be a major cost if the value of the home is significantly above your cost when it is sold.
One strategy for a principal residence lets you preserve the exemption on gains. Rent the home for a few years, then sell when the gains still are eligible for the exemption. For example, you might be able to rent for two years, and then put the house on the market. As long as it sells within a year, your gains will be exempt because you will have owned the home and used it as a principal residence for at least two of the preceding five years. To protect the tax-exempt gains, be sure to follow the calendar closely and know the rules.
A 2008 housing law amended the rules to limit tax-free gains available to those who make business or rental use of a principal residence.
Example. A married couple buys a beach house on Jan. 1, 2009, for $500,000. They rent the home for three years until Jan. 1, 2012, and then they move in and establish it as their principal residence. They plan to sell on Jan. 1, 2014. Let’s say the sale price is $1 million.
Under the new rules, they cannot exclude the entire $500,000 of gain. Three of the five years they owned the property it was a rental, which is a nonqualifying use. The home had a qualifying use for only two of the five years, so only two-fifths of the gain, or $200,000, can be excluded from gross income. The rest is taxable as long-term capital gains.
Of course, if you do not need the home’s equity to meet living expenses you don’t ever have to sell. Hold the home for life, then under current law your heirs will be allowed to increase the tax basis to its current fair market value. They can sell it right away, and no one will owe capital gains taxes on the appreciation during your lifetime.
Help in analyzing the financial aspects of the decision is available by using a spreadsheet that is free online at (ignore the hyphen): www.aicpa.org/download/pubs/jofa-/2005_06_witmer.xls.
RW May 2009.
